Chapter 7: All about startup equity

This section is borrowed/modified with permission from?Understanding Startup Stock Options ?by?Ben Belzer , Director of Engineering at Berbix (now part of Socure) . Disclaimer:?this is not legal or tax advice. Consult your own professionals before making any decisions.

Equity can be a huge incentive for joining a startup early, but knowing when to exercise your options, how to get paid out, how much you’ll make, and how much you’ll get taxed is not at all obvious. It’s important to have a solid understanding of how options work, because the way you use them can have huge financial consequences.

What is a Stock Option?

A stock option is a contract that gives you the right, but not obligation, to buy a stock at an agreed-upon price and date. The price at which you can purchase the stock is called the exercise price, or strike price. So if your employer grants you 100 options, you do not own 100 shares. Rather, you have the option to buy 100 shares at the aforementioned strike price. Doing so is called exercising your option.

Most startups give employees Incentive Stock Options (ISOs), though some use Non-qualified Stock Options (NSOs). For this post we’ll assume that we’re only dealing with ISOs.

Understanding the Equity Component of an Offer

There are a few key components to an equity offer that you should always look for.

• Number of Options.?The number of shares you have the right to purchase.
• Percentage Ownership.?Your percentage ownership of the company’s total outstanding equity, assuming that you exercise all of your options. This is calculated as (number of options) / (total outstanding shares issued by the company).
• Strike Price.?The per-share price that you pay to exercise your options.
• Vesting Schedule.?Typically your equity grant will be subject to vesting, which means that you don’t receive all your options right away, but that you’ll receive them over time. A typical vesting schedule is four years with a one-year cliff. This means that if you leave the company within your first year, you’ll walk away with nothing. If you stay, 1/4th of your shares will vest on your one-year anniversary, after which 1/48th of your shares will vest monthly. There are plenty of other vesting schedules too. Some companies have a five-year vest with a six month cliff. At Amazon, 5% of your shares vest after year one, 15% after year two, then 40% after years three and four.
• Post-Termination Exercise (PTE) Window.?If you leave your job, you’ll often have just 90 days to decide if you want to exercise your options. Once those 90 days are up you forfeit all your options, causing many employees to find themselves in “golden handcuffs”. Luckily, some companies like Pinterest and Asana are starting to do 5, 7, or 10 year PTE windows. Be aware, though, that even if your PTE window is more than 90 days, your ISOs will convert into NSOs after 90 days.

When should I exercise my options?

Exercising your options can be expensive, so deciding when to exercise is going to depend on your personal financial situation. However, it’s important to understand all possibilities and the enormous tax implications that come with each one.

Exercising one year before IPO

One of the best times to exercise your options is one year before the IPO, as described by Wealthfront ?here . If you exercise your options one year before selling and your grant date was at least two years prior to the date you sell, you’ll only have to pay long term capital gains tax on your profit, rather than the much higher typical income tax rate.

If the fair market value (determined by the most recent 409a valuation) of your company’s shares has risen above your strike price, you may also have to pay Alternative Minimum Tax (AMT) at the time you exercise your options. The federal AMT rate is 28% of the spread between the fair market value of your shares and the value of your shares at your strike price.

The problem preventing many people from using this approach is that it often requires fronting a significant amount of cash to exercise your options. If that’s the case, you can wait until after the IPO to exercise your options.

Exercising and Selling Post-IPO

If you can’t afford to exercise your stock options, but your company has already gone public, you can arrange a cashless exercise. In a cashless exercise, your employer or a brokerage firm will give you a loan to exercise the options, then sell the stock at market price immediately. You then use the proceeds from the sale to repay the loan. This is quite common at startups where employees can’t afford to exercise their options. Typically the mechanics of the process of receiving the loan, selling the stock, and repaying the loan is hidden from the employee, and he or she will simply receive the proceeds after the whole transaction is complete. The downside to this approach is that your gain from selling the stock will be taxed as ordinary income because you’ve held the stock for less than a year.

Early Exercising

Many startups allow their employees to exercise their options before they’ve vested, which is referred to as early exercising. Early exercising is a good idea when you either have high confidence that the company will have a successful exit or the total cost to exercise is affordable. This approach has 2 major advantages:

1. You’ll owe zero AMT at the time you exercise your options if your strike is equal to the company’s last 409a valuation.
2. The 1-year countdown to qualify for long term capital gains tax starts ticking.

Keep in mind, though, that early exercising is risky. You should only early exercise if you are comfortable losing your entire investment.

The cost to early exercise varies drastically depending on the stage of the company. If you’re at a seed stage startup, your strike price could be $0.01. In this case, early exercising 50,000 options would cost you $500. At a Series A stage company, however, your strike price could be around $0.50. Early exercising 50,000 options at that price would cost you $25,000.

If you choose to early exercise?it is absolutely crucial that you file an?83(b) election ?within 30 days?to inform the IRS of your decision. If you don’t file an 83(b) election form, you’ll be hit with additional taxes when your options vest.

What happens if you leave before your options have vested?

If you early exercise your options and leave before they’ve all vested, the company typically has 90 days to repurchase any of your unvested shares at the same price you paid. If they fail to do so after 90 days, all the unvested shares are yours. This can vary across companies though, so you should check your option grant letter or ask your employer.

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Now that you're versed in startup equity, think about how much startup equity matters to you as part of your compensation package. The younger the company you join, the more options you'll be issued (generally speaking).

If you have an equity range in mind that you're looking for, you can filter by equity on YC's job board .